The banking system must change, argues economist Larry Kotlikoff, as the US government cannot continue underwriting Wall Street. Photograph: Mark Lennihan/AP

The 1946 classic It's a Wonderful Life, starring Jimmy Stewart, is an uplifting tale about the difference a good, honest bank manager has made to the lives and fortunes of his hard-working clients – revealed with help from a friendly angel.

Unfortunately, as a new book from Boston University professor Larry Kotlikoff points out, banking isn't quite like that any more. In fact, as his title has it, Jimmy Stewart is Dead.

Kotlikoff argues forcefully that the deregulation of the financial sector over the past 20 years has created an extraordinary situation where today's bank bosses – from bridge-mad Jimmy Cayne of Bear Stearns, to the terminally egomaniacal Dick Fuld at Lehman – have been free to gamble with our money.

"These guys, they flunked out of college, they were smoking dope," he says of bosses generally. "The problem is the leveraging of the taxpayer by people with no formal training in finance or economics, no personal downside, an assortment of Napoleon complexes, the money to buy ratings in New York and policy in Washington, and the ability to run circles around regulators."

With the US government in effect underwriting much of Wall Street, through explicit bailouts such as that of insurance giant AIG, and implicit guarantees of the banks deemed "too big to fail", he reckons we're well on our way to a monumental fiscal crisis – unless the structure of the banking system is fundamentally altered.

"The US government has become AIG many times over," he says. Already deep in deficit, America doesn't have the money to meet its promises – guaranteeing consumers' deposits, for example – if another crisis ensues.

"They're selling insurance policies against events they cannot cover without printing money, which would lead to hyperinflation. If people got a whiff of hyperinflation, there would be a run on the banks. You could very quickly go from needing $4tn, to $7tn, to $10tn — that would be total collapse. Bingo, you're Germany in 1920."

For that reason – to "get the US out from under the promises that it can't keep" – he advocates "limited-purpose banking". New, pared-down financial institutions, a bit like US mutual funds, would invest savers' money into a designated asset class – residential mortgages, for example, or shares – instead of using a small core of deposits to make bets 10, 20 or 30 times larger.

Savers would know exactly where their money was going. They might make lower returns; but they would know their deposits weren't being used to fund a betting frenzy on collateralised debt obligations, or what ever crazy fad the whizz kids had come up with.

A single regulator, modelled on the US Food and Drug Administration, would ensure the banks put their funds where they had promised – preventing Bernie Madoff-type situations in which investors' cash just disappears.

And the problem of contagion, with banks fatally entangled through an impossibly complex trail of bets and counter-bets, would be eliminated. "Bear owed money to the next guy, who owed money to the next guy. You had a line of gasolene running from one bank to the next. With limited-purpose banking, each fund has its own firewall," he says.

It's radical, but the reason Kotlikoff's work is worth a read is that no less a figure than Mervyn King has repeatedly cited his analysis, even inviting him to give a seminar to Bank, FSA and Treasury bigwigs, including FSA chairman Adair Turner.

Both King and Turner have become unlikely crusaders for radical reform, as nervous politicians adopt a more cautious approach. David Cameron's announcement yesterday that he would unilaterally impose a tax on the banks – as President Obama also plans to do – is welcome, but doesn't get to the heart of the problem.

The Treasury's view is that by tweaking capital requirements for banks' riskier activities, and forcing them to draw up "living wills" to show how they would unwind in a crisis, they can avoid the need to take an axe to Britain's sprawling financial giants.

But that's a roundabout and ineffective way of approaching the problem that banks have been allowed to get too big, and too risky, while the myth has been perpetuated that consumers' deposits are safe, forcing governments to step in when things go wrong.

Kotlikoff calls this "crazy capitalism," and laments the waste of talent and resources that have been poured into the financial sector over recent decades. "Spending that much human capital to try to help such a small segment of society take away resources from other segments – that's not what America is about. This has been a terrible thing," he says.

If limited-purpose banking were implemented, making super-risky calls on real estate or junk bonds wouldn't be outlawed – it just wouldn't be legal with ordinary savers' day-to-day deposits. "These guys think they're demigods, but this is not God's work: let him do it on his own time, on his own dime and with his own house," Kotlikoff says.